REITs had a strong run last year, notching gains of nearly 28% as the sector began to recover from the real estate bust. But industry watchers are divided as to whether it is worth jumping on the bandwagon now, or waiting a few more years.
Paul Puryear, director of real estate research for Raymond James, thinks REITs will continue to turn in a solid performance this year, although he acknowledges they are unlikely to reprise their spectacular returns of 2010. "REITs were definitely helped in 2010 by lower interest rates, and that's going in the other direction now, but even so, I think we're in a period of fundamental recovery for commercial real estate and we should see more good returns in 2011," Puryear says.
When sizing up REITs, he and his team examine four metrics: multiples, net asset value, dividends and replacement cost. In spite of the sector's heady climb last year, it is trading at a reasonable level, he says. "We don't see any one metric that suggests to us that the space is substantially overpriced-but it's certainly not discounted," he adds. The stocks he follows are trading at about 10% above their net asset value (NAV). "That's about reasonable for this point in the recovery," he says. "We're in a fundamental recovery period for real estate and you'd expect them to trade above NAV because the stocks are discounting future earnings growth."
He also notes the cash flow levels of REITs are recovering after a decline that began in 2008 as the real estate bubble burst. In REITs, cash flow is best approximated by adjusted funds from operations, AFFO. Puryear expects the AFFO of the companies on his coverage list to climb 19% this year, after rising just 2.5% last year and losing 2% in 2009.
But even with cash flows on the rise, not everyone is convinced the price is right. Jim Swanson, chief investment strategist at MFS Investment Management, notes that REIT cash flows are not yet back to pre-recession levels, although their stock prices are. He compares them to other stocks in the S&P 500, which have seen cash flows bounce back. Around year-end, the S&P 500 traded at a multiple of nine or 10 times cash flow while REITs were trading at around 16 times free cash flow. Swanson notes that this is the second-highest multiple for REITs in 20 years, ranking only after prices paid at the market peak of 2006.
Swanson also says REITs are expensive compared to actual buildings. If an investor were to buy a building, it would be about 20% cheaper to do it with a bank loan than through a REIT, he says. "It's almost like buying a closed end fund at a premium. The REITs are trading at a premium to bricks-and-mortar."
If REITs are richly priced compared with other stocks, they also offer investors more yield than the S&P, although that edge has narrowed over the years. Over the last 20 years, REITs yielded an average of 6%, and now they're paying about 3% to 4%, compared with about 1.75% for the S&P. "The notion here is that people buy these things for yield, and they're not getting the yield so things have to improve quite a bit to justify the price," Swanson says.
Investors who still like REITs note that there's not much new supply of commercial real estate. So as the economy continues to recover, vacancies will go down. Combined with a possible increase in inflation if the economy continues to recover, optimists believe REITs will be sitting pretty. Rick Romano, a portfolio manager for Prudential Real Estate Investors, says: "The upside of the credit crisis is that nothing is being built." He adds that fundamentals bottomed out in 2009, and began to show improvement in 2010, which he expects to continue this year. "As the recovery occurs and demand improves, a lot of short duration leases like apartments, hotels and self-storage [facilities] are going to start to see pretty good rent growth," he says.
Romano adds that in 2009 REITs cut dividends sharply to preserve cash. Today REITs' dividend payout ratios are near historical lows, at about 63% of funds from operations. The historic norm is around 80% to 85%. Romano says if REITs start to raise dividends back toward the historic average, and assuming cash flows remain constant, there is room for 15% to 20% growth in the current dividend yield. Romano also believes cash flows will grow 5% to 10% annually in 2011 and in 2012, which could also serve to boost dividends.
Nonetheless, the cautious, like Swanson, still think prices got ahead of themselves last year. "The labor market still hasn't turned, and vacancies haven't turned strongly enough to justify a 20% jump," Swanson says. (The return of the MSCI US REIT Index in 2010 was 23.5%.)
But that doesn't mean Swanson dislikes the group. In fact, he owns several REITs in one of the mutual funds he manages, and likes the outlook for them in 2012. But as for buying more now, he says, "I'd rather underweight REITs and take that money to other stocks."
David Darst, chief investment strategist at Morgan Stanley Smith Barney, and Christian Hviid, chief market strategist for Genworth Financial Asset Management both think REITs are a bit richly priced compared with other stocks, but fairly valued compared with investment grade corporate bonds. Darst has recently reduced his recommendation for a moderate high-net-worth investor to 4% from 5%. Even with the cutback, that's still above his group's standard allocation for REITs of 3%. The slight overweight is because he expects to see growth in REITs' positive net operating income this year. "We think the momentum will gain in 2012 and 2013, and we'd note that in the private market, property values are building up 30% from the mid-2009 trough, but remain about 20% below the March 2007 peak," Darst says.
One of the reasons his analysts expect growth in the sector is that they think the economy may be turning a corner. Darst believes that rents and occupancies are bottoming out. "Companies haven't started hiring back, but they have stopped laying people off," he says. However, he adds, the sector could be hurt if interest rates were to rise more sharply than generally expected. Darst expects a yield of 4% on Treasuries at the end of this year, rising to 4.25% by the end of 2012.
But there are other bright spots that keep REITs at a slight overweight in Darst's allocation. He believes they are fairly valued compared with investment grade corporate bonds. "We saw some other areas-commodities and inflation-indexed securities-that were more compelling right now, but we still love the overweight in REITs," he says. He recommends investors focus on REITs with higher quality portfolios, and then look for REITs with growth opportunities, whether those include acquisitions or building new properties. The third characteristic he advises investors to look for is relatively low leverage. Fortunately, that's easier to find these days. During the market sell-off in 2008, REITs got hit especially hard, and many had maturities coming due and were worried they would not be able to access the capital markets. As a result, many paid down debt, and many were able to push out the maturity of their remaining debt for several years at attractive prices. Many investors are now more comfortable with the sector's cleaned-up balance sheets.
Romano of Prudential Real Estate points out that the debt-to-total-enterprise value of REITs is now around 43% or so, down from close to 60% in the darkest days of the credit crisis. Nevertheless, analysts fret that vacancy rates are still relatively high in historical terms, depending on the sector, with an average percentage rate in the mid-teens.
Genworth's Hviid says that job creation is the key data point to watch to gauge the future of REITs. "That's the critical element investors are looking at, joblessness," he says. With more jobs, rent will likely strengthen as vacancy rates drop.
But in the meantime, Hviid says, there's been no real pickup in demand for real estate. Retail has turned in middling performance, while office space is still rather weak. He notes that in Los Angeles, anecdotal evidence says that vacancy rates are 20%. "It's hard to ask for higher rent when a fifth of the building is empty," Hviid says. One of the strongest sectors has been apartments, which has benefitted from weakness in another area of real estate: new homes. Weak home values continue to weigh on that market. In fact, Hviid's favorite group isn't really a group within the traditional REIT sector at all, but real estate service companies, which help other companies find space to lease. He says that even though demand hasn't been as robust as it might be, these companies will be among the first beneficiaries when demand finally rebounds.
Hviid says major coastal areas in the U.S.-like New York, Washington, D.C. and San Francisco-with diversified industry exposure and ties to global trade or politics, have more stability and demand. Meanwhile, rural parts of the country are having a tougher time filling vacancies. He suggests investors look outside the U.S. to markets like Singapore and Hong Kong that have limited supply of real estate, and therefore enjoy robust pricing power. "It pays to diversify globally when you're looking at REITs," he says.
Romano also would like to see unemployment go down in order to spur demand, which he admits is a bit weak at this point. But, he says, "the offset to that is that supply additions are historically so low, you don't need historic demand levels to increase occupancies and rent."
In speaking with advisors, Romano says their biggest worry has been that the amount of debt from REITs maturing this year and in 2012 and 2013 would cause distress in the industry and lead to many distressed properties coming up for sale, pushing prices even further down. He says these fears are misplaced. "So far banks have been extending a lot of these loans because they're covering cash flow. And REITs have been looking for this opportunity because their balance sheets are in good shape, so they can acquire these properties from banks and get some cash flow-accretive properties."
Romano adds that the market has not seen many distressed properties in any case, and that as fundamentals strengthen with an improving economy, he expects that trend will continue. What's more, he says, the headline-grabbing distressed properties, such as the Stuyvesant Town apartments in New York City, have generally not been held in REITs, but rather, in private deals.
Instead of worrying about a few high-profile deals, Romano and other investors are keeping their eyes on the progress of office buildings, shopping malls and other properties as the economy continues its slow recovery. ows